It’s been a banner year for bank stocks, with the KBW Nasdaq Bank Index jumping 32% year to date, easily beating the S&P 500’s 18% advance.
Bank of New York Mellon (NYSE: BK) shares have done even better, surging 54% to a market capitalization of $82 billion.
So what has driven the oldest U.S. bank to such a dizzying height? (Bank of New York was created by Alexander Hamilton, one of the country’s founding fathers, in 1784, and Mellon Bank was created by the renowned Mellon family in 1870).
It’s the custody business that has propelled the bank. BNY Mellon is the largest custodian bank in the world, with over $58 trillion in assets under custody or administration.
Scale, client stickiness
“While core custody can be an undifferentiated offering, the firm’s scale and client stickiness have helped generate double-digit returns on tangible equity,” writes Morningstar analyst Rajiv Bhatia. That metric registered 25.6% in the third quarter, up from 22.8% a year earlier.
BNY Mellon’s investment servicing segment includes asset servicing for investors, along with corporate trustee and depositary receipts, such as ADRs, for securities issuers. American Depositary Receipts are dollar-based shares of foreign companies. BNY Mellon is the biggest provider of depositary receipts in the world.
BNY offers clearance and collateral management, which totals about 7% of revenue. That business has a competitive advantage in that it’s the only provider of tri-party repurchase agreements for U.S. government securities, Bhatia notes.
A tri-party repo is a short-term financing deal, where a third-party agent (BNY Mellon) manages the collateral (securities) between the cash lender and the borrower. BNY handles collateral selection, custody, valuation, and settlement. That minimizes operational burden and risk for the main parties, which is crucial for dealers needing funding and investors seeking safe, liquid investments.
Asset management business, earnings
Meanwhile, Pershing, which BNY purchased for $2 billion in 2003, provides broker/dealer clearing and registered investment advisor custody services. Registered investment advisors are wealth managers. “That has been a bright spot for BNY,” Bhatia said. “We expect Pershing to continue to benefit from the secular growth of RIAs.”
Finally, BNY Mellon has a $2 trillion asset management business that generates about 25% of the bank’s revenue. Given the low switching costs for that service, he views it as a smaller competitive advantage for the bank than its investment servicing division.
As for earnings, BNY’s revenue climbed 9% in the third quarter from a year earlier to a record $5.1 billion. Earnings per share surged 25%, and the pre-tax operating profit margin hit 36%, up from 33%. The stock has returned an annualized 40% over the past three years, 25% over the past five years, and 12% over the last 10 years.
Analysts are optimistic about BNY Mellon’s future, given its fundamental strength. But they are cautious about its valuation. The bank has a forward-price earnings ratio of 14.3, well above its five-year average of 10.9.
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